Development Policy Review, 2005, 23 (6): 643-663

Why Do Aid Agencies Exist?

Bertin Martens
This article seeks to explain the organisational set-up of foreign aid
delivery from a Coasian perspective: Why are there many and different aid
organisations and not just one? Why is foreign aid not transferred directly
from donor to beneficiary? With zero transaction costs and fully shared
preferences between donors and beneficiaries, there would be no need for
aid agencies. Their role is not so much to transfer funds or goods and
services to developing countries, but (a) to reduce ex-ante transaction
costs and (b) to mediate between the diverging preferences of donors and
recipients, and package aid flows in a contract that reduces ex-post
uncertainties for donors. Outcomes differ according to types of agencies
and aid delivery instruments.

1 Introduction

In his famous article on The Nature of the Firm, Ronald Coase (1937) sought to
answer the question why firms exist, why there are many firms and not just one, and
why people work in firms rather than as individuals. He suggested that transaction costs
could explain the boundaries of the firm, and this suggestion later gave rise to an
abundant literature on vertical integration. Turning from commercial firms to aid
organisations, we could ask similar questions: Why do aid agencies exist? Why are
there many aid organisations and not just one? Why are there different types of aid
organisations (NGOs, bilateral and multilateral grant agencies, development banks)?
Alternatively, why is foreign aid not transferred directly from a single donor to a single
beneficiary, rather than going through the hands of multiple persons and organisations?
In other words, how can we explain the organisational set-up of foreign aid delivery?
To answer these questions, we first need to determine what aid agencies actually
do. At the most general level, foreign aid agencies can be defined in contrast to
domestic income redistribution agencies, such as government agencies dealing with
medical and unemployment benefits. While domestic aid agencies redistribute income
between donors and recipients living in the same political constituency, foreign aid
agencies target recipients living outside the donors constituency, usually in developing
countries. Split constituencies have major implications for the decision-making process.
In domestic aid, both donors and recipients have voting rights and can influence the
political decision-making process. In contrast, in foreign aid the feedback loop between
recipients and decision-makers is broken; only donors have political leverage over the

European Commission, 200 rue de la Loi, B-1049 Brussels, Belgium (bertin.martens@cec.eu.int). Earlier
versions of (parts of) this article were presented at workshops at Pompeu Fabra University (Barcelona), the
World Bank, the Swedish International Development Agency, the Overseas Development Institute (UK)
and the HWWA (Hamburg). The views and opinions contained are those of the author and do not
necessarily reflect those of the European Commission.
Overseas Development Institute, 2005.
Published by Blackwell Publishing, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
644 Bertin Martens

decision-making process. This broken feedback loop explains the origins of the
ownership problem that is so frequently mentioned in connection with foreign aid, but
rarely if ever in connection with domestic income redistribution. Ownership problems
occur when donors can impose decisions on recipients, without the latter having a say in
the process.
At a more functional level, the role of aid agencies can be described in terms of the
contents of their activities. One possible perception is that aid agencies deliver goods
and services to developing countries, such as food, education, health services,
infrastructure, knowledge, etc. The weakness of this point of view resides in the fact
that these goods and services can be bought by developing countries on world markets;
there is no specific need for aid agencies to deliver them. One could, of course, point
out that developing countries are poor and cannot afford to buy these goods and services
in the market. This would imply that the main function of aid agencies is to organise
financial transfers. But why would that require such complicated procurement
procedures, the elaboration of development strategies, active aid agency involvement in
the minute details of the design and implementation of projects, etc.? Surely, the
beneficiary of the transfer could take care of all that. Sending a cheque from the
treasury of the donor country to that of the recipient country would be sufficient in that
case. Obviously, foreign aid agencies are more than just a financial transfer mechanism.
They are actively involved in spending decisions, on both the donor and the recipient
side.
This article will argue that the main role of aid agencies is to solve the ownership
problem that is caused by the broken feedback loop in foreign aid. They do this through
mediation between donors and recipients interests, or preferences. Though donors
remain the main decision-makers in foreign aid, mediation is necessary because
virtually all aid programmes require some agreement from the recipients as well, if only
to authorise that the programme be implemented on their sovereign territory. There is
no need for mediation when donor and recipient interests are fully convergent or, in
economic terminology, when their preferences are aligned. In that case, they both fully
agree on how to spend the financial transfer and there is no need to negotiate a contract;
there is full joint ownership. Mediation implies that there is no full ownership by either
the donor or the recipient. In most cases, ownership will be partial and shared in
accordance with an agreed contract: both donor and recipient obtain a partial fulfilment
of their preferences. Like every contract, aid contracts are necessarily incomplete and
some of the activities and results will be costly to verify. As a result, moral hazard and
adverse selection are inherent in aid delivery. Donors will search for appropriate
delivery instruments that minimise these risks, for a given cost. This article aims to
explain the role that different types of aid agencies and aid instruments play in
mediation between donors and recipients and in the management of the resulting
contractual costs and risks.
A voluminous literature has emerged in recent years focusing on justifications for
the existence of multilateral aid organisations, especially the Bretton Woods pair, the
IMF and the World Bank (Gilbert and Powell, 1999: 459; Milner; 2002; Hawkins et al.,
2003). In general, however, research that investigates the role, incentives and biases of
donor agencies is quite scarce (Quarles et al., 1988; Carr et al., 1998; Ostrom et al.,
2001; Martens et al., 2002). This stands in stark contrast to the growing volume of
research on the (in)effectiveness of aid (for instance, Burnside and Dollar, 1996, 2000;
 Why Do Aid Agencies Exist? 645

Tsikata, 1998; Hansen and Tarp, 2000). Why do all these aid organisations continue to
exist and even to flourish if they are not effective in relieving the developing world
from the plight of poverty? Clearly, their continued existence indicates that they are
useful, though not necessarily for the reduction of poverty in the beneficiary countries.
Their usefulness may well reside in the production of mediation services for which there
is a demand and for which their clients (donors, recipients) are willing to pay. This
would imply that an aid agencys performance should not be assessed in terms of
improving welfare in beneficiary countries but rather in terms of the efficiency and
effectiveness of its mediation.
One drawback of the existing literature is that there are no attempts at cross-
institutional perspectives to explain the relative advantages and disadvantages of each
type of agency within a single explanatory model. The role of a generic aid organisation
is often approached within a model of economic growth and development: how loans or
grants can contribute to economic growth. This does not explain how a particular type
of aid agency or aid instrument affects aid performance. The present article aims to
explain the range of diversity of aid organisations within a single approach.
The article starts from a very simple model of direct redistribution between a
donor and a beneficiary, with zero transaction costs and full alignment of preferences,
and thus no moral hazard or adverse selection. It demonstrates that there is no need for
an aid agency in this case. The model is then expanded to take account of positive
transaction costs, non-aligned preferences and asymmetric information. This induces the
risks of moral hazard by the agent and adverse selection by the principal and the
principals need to incur transaction costs to improve information and reduce
uncertainty regarding the outcome of the transaction. This is where aid agencies come
into play. Various institutional arrangements (types of agencies and types of
instruments) differ in their ability to reduce these risks in particular circumstances, and
affect the level of transaction costs but also the benefits that donors and recipients
derive from the transaction.

2 Private voluntary aid and preference alignment

Aid income redistribution between humans is a phenomenon that is deeply
embedded in human behaviour. Indeed, we could not survive without it. For instance,
sharing food and other basic resources in families and kin groups is essential for the
survival of human beings as essential as it is for most other animals. What
distinguishes humans from other animals, however, is our ability to redistribute and
share resources within a much wider social setting, outside immediate family and kin
groups, even with persons we have never met or will never meet. This article focuses on
foreign aid, worldwide redistribution to far-away places and people.
What motivates people to redistribute part of their income voluntarily to others?
Carr et al. (1998) explain redistribution as a cognitive process in the human mind. When
a potential donor encounters individuals deprived of essential resources that the donor
possesses, it may generate empathy and cognitive dissonance in his mind: the observed
situation of the deprived does not correspond to his own perception of how the world
should be. This may trigger a response that seeks to modify the situation in such as way
as to alleviate this dissonance, in this case via an attempt to redress the relative
imbalance in resource allocation. Redistribution can thus be considered as a transaction:
646 Bertin Martens

the donor transfers resources to the recipient in return for a reduction in dissonance in
the donors mind. Dissonance reduction is a form of consumer satisfaction. It is
achieved only if the transfer does indeed change the recipients situation in line with the
donors expectations. If the donor had incorrect expectations about the recipients
response to the gift, and observes a different behavioural response, donor dissonance
will not be reduced and may actually increase. An important conclusion is that donors
and recipients should have identical or at least closely aligned preferences
concerning the use of the transfer, in order to achieve a successful transfer in which
both donor and recipient utility is increased.
I came across an example of this pure form of aid when, walking around on a
warm evening in Key West, Florida, my wife and I encountered a person sitting on the
sidewalk, holding up a begging bowl with a written statement Why lie? I need a beer.
My wife immediately reached into her purse and contributed to the beneficiarys beer
consumption. Initially, I was surprised by the frankness of both the donor and the
beneficiary. Thinking it over, however, I could see that this was a case of identical
preferences: my wife was feeling thirsty and longing for a cold beer and fully shared the
beggars preference to allocate every penny to that purpose. Sharing her money with
him reduced her cognitive dissonance about his situation. There was no need for an aid
organisation as an intermediary: donor and recipient met face-to-face and the
momentary exchange of information (the beggars written statement) was sufficient to
transmit a credible message to the donor about the recipients preferences and the use he
was going to make of any additional revenue that evening and this preference turned
out to be perfectly aligned with her own. There was no need for conditionality. Money
was transferred in return for a reduction in the donors cognitive dissonance and an
increase in the recipients beer consumption; it was a welfare-increasing transaction for
both.
Carr et al. (1998) distinguish between distributional and situational responses to
perceived deprivation, depending on whether or not the potential donor perceives the
deprivation as being due to environmental factors outside the control of the deprived.
Situational interpretations may cause non-alignment of preferences, despite direct face-
to-face meetings and exchange of (often tacit) information. If poverty is perceived as
the result of the depriveds own choices, it indicates that his behavioural preferences are
out of line with those of the potential donor: he could have done otherwise and avoided
ending up in this situation. Consequently, an income transfer to the deprived is likely to
result in more wrong choices and thus be meaningless, at least from the donors point of
view. The donor may still be induced to transfer resources if he has leverage over the
use of the transfer, to direct its use in line with his own preferences. Preference
misalignment between donor and recipient can be corrected through tied or conditional
aid aid that puts restrictive conditions on the recipients use of the resources and
thereby reduces the discretion or ownership rights of the recipient, leaving at least some
discretion to the donor. Conditionality is the price to be paid by the recipient in order to
get access to transfers in case of non-aligned preferences.
Most foreign aid is conditional. Two major types of conditionality can be
distinguished. The first type, input conditionality, restricts the recipients discretion in
the spending of the resources and ties it to procurement conditions, be they geographical
(procurement of goods and services in the donor country) or procedural (specific
procurement and spending procedures agreed with the donor). The most typical form of
 Why Do Aid Agencies Exist? 647

input conditionality is traditional project aid. Projects tie income transfers to a wide
range of procedures that increase donor leverage over project inputs and activities: the
donor owns a large stake in the management of the project. Commercially tied aid is
another form of input conditionality. The OECD/DAC (OECD, 2005: Table 23)
statistics show that the extent of commercially tied aid varies widely among donors,
from 0.1% of all Norwegian aid to 48% of Canadian aid.
The second type of conditional aid, output conditionality, ties aid to changes in the
recipients behaviour and institutions (specific policy decisions, institutional reforms,
etc.). However, the recipient retains most of the responsibility for management in this
case. Burnside and Dollar (2000) demonstrate how aid has no noticeable impact on
economic growth in the recipient country unless it is instrumental in triggering policy
reforms that the country would not undertake otherwise. In other words, unless it is
conditional on a change in the recipients behaviour. The Burnside and Dollar article
has triggered a vast debate in the aid literature on the link between aid and growth.
Since the 1980s there has been a shift away from input conditionality towards
output or result-based conditionality, mostly in the form of budget support and
structural adjustment programmes but also in more traditional project aid. Recently,
donor policy seems to be moving even further away from conditionality and towards so-
called partnership and (co)ownership programmes; see, for instance the Paris
Declaration on Aid Effectiveness (2005). As shown above, full ownership by both
donor and recipient is possible only when their preferences are fully aligned which is
rarely the case. As such, the shift in aid semantics towards softer and less
conditionality-based terminology does not change the fundamental issue. Clearly,
differences in preferences between donors and recipients, and the search for more
efficient solutions to manage these differences in a less costly way, play an increasingly
important role in aid flows. We should therefore move beyond the simple approach and
allow for non-aligned preferences and non-zero transaction costs.

3 Ex-ante and ex-post transaction costs in aid transfers

All transactions, including income transfers between donors and recipients, entail
transaction costs (Coase, 1937; North, 1990; Williamson, 1985). There is no single and
generally accepted definition of transaction costs in the New Institutional Economics
literature (Furubotn and Richter, 1998; Masten and Williamson, 1999). Two main lines
of thought can be identified. North (1990) and Coase (1937) define them as the
effectively realised opportunity costs of organising a transaction: the costs of searching
for a trading partner, finding the right information, measuring quantities and qualities of
the traded goods and services, and negotiating a contract, plus monitoring and
enforcement of that contract. Williamson (1985) starts from the assumptions of
imperfect and asymmetric information between transaction partners and opportunism or
self-interest seeking with guile. In his view, these are the root causes of a key attribute
of transactions: uncertainty. Uncertainty can be overcome through contractual
arrangements or governance structures that include commitment devices to contract
execution, which are costly to negotiate ex-ante and to enforce ex-post of contract
signature. Uncertainty is thus considered to be the reason why parties in an exchange
invest in finding suitable partners and products, spend time on measuring qualities and
quantities, negotiate a contract and invest in enforcement devices. In sum, this is the
648 Bertin Martens

reason for incurring realised transaction costs so as to avoid potentially larger but
hopefully un-realised transaction costs during or after contract execution. Williamson
(1985) then shows how various organisational or governance arrangements entail
various degrees of efficiency in the underlying commitment devices for the execution of
agreements, and thereby different levels of efficiency of production. Different
governance arrangements result in different cost structures with respect to ex-ante
(search and negotiation) and ex-post (enforcement) transaction costs.
The Coase-North and Williamson definitions of transaction costs can be integrated
in a single framework. For a given institutional setting, there is a trade-off: the more we
invest in ex-ante realised transaction costs, the lower the potential ex-post costs (Figure
1). Improvements in institutions can be captured by a shift in the trade-off curve. An
improvement in institutional architecture must produce lower ex-post uncertainty for a
given level of ex-ante transaction cost or, conversely, lower transaction costs for a given
level of ex-ante uncertainty.

Figure 1: The trade-off between transaction costs and uncertainty

In the case of (foreign) aid transfers, ex-ante and ex-post transaction costs can be
traced back to the various activities in the aid delivery process:

(a) The ex-ante transaction costs for the donor to obtain information about the
deprived (who and where they are, what is the source of their problems and what
are their needs) and effectively carry out the transfer (money, but also material aid,
technical assistance, etc.);
(b) The ex-post uncertainty about the recipients intentions concerning the use he is
going to make of the transfer (assessing the extent of preference alignment
between donor and recipient).

In terms of Figure 1, the one-to-one aid transfer example given above is situated
close to the origin of the diagram, where both transaction costs and residual uncertainty
are (nearly) zero. Geographical separation, as well as differences in preferences between
donors and recipients, results in positive transaction costs and uncertainty about the
outcome. It shifts the aid transfer plainly into the centre of the diagram. This creates an
 Why Do Aid Agencies Exist? 649

opportunity for institutional entrepreneurs to supply institutional arrangements (aid

agencies) that shift the transaction cost trade-off curve to a higher level of efficiency,
i.e. lower transaction costs for a given degree of uncertainty. In return, donors and
recipients are willing to pay aid agencies for their services.
The concept of transaction costs has been mainstreamed in recent years in the
development aid literature. It refers to the administrative and management costs of aid
flows, which should be reduced through harmonisation of procedures among donors.
This looks like an economies-of-scale argument, rather than a reference to uncertainty
in transactions. As such, its current use in the development aid literature could be
considered close to the original Coase (1937) interpretation. This makes it difficult to
see the trade-off between the costs and benefits of transaction costs. The present article
does not stick to this simplified interpretation; it applies the combined North-
Williamson interpretation.

4 Intermediation by NGOs
The simplest example of direct one-to-one private voluntary redistribution between a
single donor and a single recipient rests on assumptions of both geographical and
preference proximity. In reality, of course, transaction costs are far from negligible,
especially in foreign aid where potential donors and recipients may live thousands of
miles apart, are unlikely ever to meet each other, and come from very different cultural,
social and economic backgrounds so that preference alignment between them is
unlikely. Despite these formidable barriers foreign aid has reached unprecedented
historical proportions. At the dawn of the twenty-first century, it has become a full-scale
multinational industry with an annual turnover estimated at nearly US$70 billion
(OECD, 2005). Direct contact between potential donors and recipients would not be
able to achieve such massive transfers. Some sort of organisational set-up is required to
facilitate intermediation between them and reduce ex-ante transaction costs as well as
ex-post uncertainty to an acceptable level.
The archetype of intermediation in foreign aid is the missionary: s/he mediates
between potential donors in their home town and potential recipients in their mission
town. Individual missionaries as well as missionary organisations may generate two
types of savings in transaction costs:

they reduce real transaction costs through economies of scale in search costs:
information and appreciation of the plight of the potential recipients,
transmission of information to potential donors; and
they reduce ex-post uncertainty by ensuring preference alignment between
donor and recipient communities. Missionaries apply the moral and religious
values of their community of origin to select recipients in their missionary
community.

Individual missionaries and missionary organisations are the forerunners of a more

general type of private intermediation in voluntary foreign aid transfers: non-
governmental organisations (NGOs). NGOs constitute a first step towards a more
complete answer to the intermediation problem between donors and recipients.
650 Bertin Martens

What are NGOs? There is a bewildering range of types and varieties of NGOs.
Some authors define them as non-profit or voluntary organisations; others emphasise
their grassroots origins as peoples organisations; yet others insist on particular types
of legal status or non-governmental aspects (Tvedt, 1998; Anheier and Seibel, 1990).
Some indeed are truly voluntary grassroots non-profit organisations. Others pursue
more profit-related objectives in a covert way, paying their staff handsome salaries or
having some form of non-official linkages with government organisations. Some may
actually be established by government departments and politicians.
For the purpose of this article I emphasise the non-profit aspect and define NGOs
as private organisations, set up by members, that pursue a single or a range of issues
without a financial profit motive in mind (though financial constraints are obviously
present). Usually, the issue is of a normative nature, driven by cognitive dissonance
that members experience in a particular domain: the world is not as we would like it to
be and we want to do something about that. This being so, the activities of an NGO are
driven by a mission or an issue. Individuals become members of an NGO because
they share a (set of) preference(s) that they would like to convey to the rest of the world.
Finding an audience that is receptive to the issue and willing to adapt its behaviour in
line with the issues perceived requirements is the primary concern of NGOs. NGOs
may be single-issue organisations Save the whale or may seek to promote a wider
range of issues covering an entire policy domain such as environmental concerns,
democracy, human rights or religious causes.
The narrower an NGOs range of objectives and the more homogeneous the
preference set of its members, the more focused its actions can be. In terms of Figure 1,
this means less uncertainty in the achievement of a given objective, for a given level of
transaction costs, as compared with an NGO with a wider range of objectives. Broad-
spectrum NGOs are more likely to encounter inconsistencies and trade-offs between
various objectives (Holmstrom and Milgrom, 1991; Tirole, 1994). They will try to
control these by investing more in transaction costs, or will simply let the objectives slip
into uncertainty for a given level of transaction costs. The extent of slippage may
depend on the visibility or measurability of the aid objective.
Private for-profit companies seek to maximise profits, a relatively easily
measurable objective (despite some evidence in recent years to the contrary). However,
the achievement of an NGOs objective(s) is usually much harder to verify. Therefore,
an NGOs best bet to enhance its credibility is to pursue vigorously activities that are
perceived to be in line with its objective(s). Activities, not necessarily achievements,
constitute the core of an NGOs business. This vigorous drive may also be the NGOs
comparative advantage. For a given budget, NGOs maximise activities in line with the
issue until the budget is exhausted. Commercial companies, on the other hand, when
faced with a fixed budget, will minimise costs in order to maximise profits. These
typical characteristics of NGOs make them well suited for the delivery of foreign aid.
They are in a position to provide ex-ante as well as ex-post transaction cost-reducing
intermediation between potential donors and beneficiaries.
Though private voluntary aid channelled through NGOs is more transaction-cost
efficient than direct one-to-one aid transfers, it accounted for about US$10 billion or
only 14% of total ODA flows in 2002, of which about US$1.2 bn was provided by
 Why Do Aid Agencies Exist? 651

governments, not private gifts.1 We need to turn our attention to the largest chunk of the
$70 billion annual foreign aid flow to developing countries, official bilateral aid
channelled through official foreign aid agencies. How do they come into the picture?

5 Official (bilateral) aid agencies

Selecting for preference alignment between donors and recipients is one way of
providing an efficient institutional arrangement for aid delivery. Often, however, donors
seek to promote objectives for which it is difficult to find like-minded beneficiaries.
Preferences may even differ among donors themselves. This requires more strongly
leveraged intermediation, strong enough to negotiate an acceptable compromise
between the preferences of various parties. At that point, NGOs become inefficient and
official bilateral aid agencies come into the picture.
In many ways, the characteristics of official aid are the very opposite of the direct
voluntary private aid model we started from. Official aid is not voluntary; it is paid from
enforced taxation. The taxpayer i.e. the primary donor may actually disagree with
the aid and be unwilling to give it. Official aid is not always triggered by the donors
desire to reduce cognitive dissonance in his mind, though some taxpayers may have a
genuine interest in the well-being of the recipient. As a consequence, official aid may
come with a lot of conditions attached to it, which the recipient may not like. Aid may
be tied to the acceptance of technical assistance and commercial supplies from the
donor country; it may be conditional on adopting policy changes and implementing
institutional reforms that do not conform to the recipients own preferences; it may
supply goods and services that do not conform to the recipients own standards, etc.
With official aid, we leave the rather idealised world of preference alignment between
donors and recipients, for a world where transfers are used to influence the behaviour of
both donors and recipients alike.

5.1 Non-alignment of preferences between donors

There is a voluminous literature analysing the motives and behaviour of bilateral aid
agencies. See, for instance, Alesina and Dollar (1999) for an overview of the Who
gives aid to Whom and Why (WWW) literature. The WWW literature looks at
volumes of aid flows between donors and recipients and tries to link these to indicators
of recipient needs (poverty) and the commercial, political and other interests of donors.
Most of this literature concludes that donors with former colonies allocate their aid
predominantly to these countries, with a view to maintaining and deriving further
benefits from this privileged historical relationship. By contrast, donors without a
colonial past seem to allocate aid more readily according to recipient needs, i.e. poverty
indicators. However, recent more microeconomic research casts some doubts over these
conclusions. Ostrom et al. (2001) demonstrate that, despite the absence of colonial ties,
Swedish aid a high-ranking good donor in the index of the Global Development
Centre (Roodman, 2004) still pursues commercial interests. Only, the absence of

1. According to Tvedt (1998), private donations account for less than 20% of NGO foreign aid resources in
most European countries. In the US, however, nearly all NGO development aid funds are private
donations.
652 Bertin Martens

historical ties implies that these countries care less about where to target their
commercial interests. It leaves more flexibility to marry the interests of the genuine aid
lobby with those of the commercial lobby. It illustrates how deceptive aid allocation
judgements at country level can be, when compared with within-country allocations and
uses. There is obviously more going on behind the scenes of bilateral aid than the
macro-approach of the WWW literature is able to reveal.
Several different motives and corresponding interest groups can be identified on
the donor side in a stylised way:

First, part of the electorate in a developed country may genuinely favour the
use of tax revenue for wealth transfers to developing countries. Here, the
overall motive could be described as poverty alleviation, which is often
perceived as an extension of a more general domestic welfare programmes
agenda (Lumsdaine, 1993). Other genuine motives are the causes that NGOs
pursue: the promotion of human rights, womens empowerment and
environmental issues, or even such mundane causes as the pursuit of adequate
accounting standards or establishing an industry association. In all these
instances, the direct beneficiaries of the aid are the like-minded persons and
organisations they work with; there is preference alignment between donors
and recipients.2
Second, aid services suppliers, or, in general, suppliers whose products and
services could be valuable in developing countries, may want to use aid
transfers to enhance their positions on developing country markets (technical
assistance, commercial suppliers, but also academic and research institutes,
laboratories, construction companies, etc.). Here, the aid is instrumental in
bringing about a preference re-alignment in the mind of the recipient who
gets a subsidy to do something he would otherwise not do, or to do it
differently.
Last but not least, a donor country government may use aid flows to enhance
political alliances with the recipient country government, to obtain political
goodwill and changes (non-alignment in the original preferences) in the
decisions and policy stance of that government. Donor governments may also
wish to nurture their relationship with particular interest groups in the recipient
country (preferences aligned with those of the donor government) who can be
influential in political and economic decisions of interest to the donor country.

In spite of heterogeneous, and possibly conflicting, preferences, bilateral aid seems

to be able to mobilise much larger aid flows than private voluntary aid. Indeed, the vast
majority of all foreign aid is non-voluntary aid, mobilised through enforced taxation in
donor countries (OECD, 2005: Table 2). How can we explain the dominance of this
type of aid, despite the fact that it takes us far from the ideal aid model with full
preference alignment? What are the incentives that drive these heterogeneous interest
groups to form a coalition?

2. Though the target of their activities may be to change the behaviour of not-so-like-minded persons and
organisations.
 Why Do Aid Agencies Exist? 653

The preferences of these donor interest groups are not mutually exclusive. They
share a common objective: they all want to maximise aid flows in order to achieve their
preferences. A single aid project can benefit all three. For instance, a bilateral aid
agency may approve the delivery of water pumps to a village in the recipient country.
Such a project satisfies the preferences of all donor interest groups: genuine wealth
transfers and empowerment of (water-carrying) women, profits for commercial water
pump suppliers and consultants involved in the project, visibility for the donor
government, political goodwill from the influential village politician in support of the
political interests of the donor country.
Another and possibly stronger incentive is savings in opportunity costs, or
increased consumer surplus, for interest groups. If aid were to be supplied from private
financial contributions only, and individual donors were to contribute up to the level of
their willingness to pay for aid, the consumer surplus would be minimised to zero. On
the other hand, with aid being supplied from tax revenue, the cost of contributions is
probably far below the willingness to pay of interested lobby groups, especially since
the opportunity cost of enforced tax money is basically zero: consumers have no choice
but to pay taxes. Supplying aid from tax revenue thus greatly increases the consumer
surplus of potential individual donor interest groups.
Collective action among different interest groups is easier to achieve if they jointly
delegate decision-making to a common agent, the official government aid agency. Joint
delegation may worsen the typical problems of multiple and conflicting objectives, with
poorly defined trade-offs, that negatively affect the organisations performance
(Holmstrom and Milgrom, 1991). On the other hand, while these multiple principals
have different objectives and are likely to give incoherent instructions to the agency, the
agency may be in a position to make its own proposals, play off different interest groups
against each other, forge coalitions in support of the policies it proposes, induce
collective action among members and, in general, achieve objectives that individual
members would not be able to achieve on their own (Martimort, 1991). Consequently,
one important task of bilateral donor agencies is to mediate between donor interest
groups at home.

5.2 Non-alignment of preferences between donors and recipients

Bilateral agencies not only seek to mobilise the largest possible coalition of donor
interest groups at home. They also have to deal with the possible lack of alignment of
preferences between donors at home and recipients abroad. Commercial aid services
suppliers may actually be interested only in the delivery of project inputs (the sale of
goods and services), rather than in the results. Donor politicians who seek visibility and
goodwill abroad may also be interested mainly in visible delivery of inputs, and not so
much in producing results. There is little risk of moral hazard or ex-post uncertainty in
such cases. However, genuine aid lobby groups in donor countries are interested in
achieving results downstream of inputs delivery. In that case, bilateral agencies have at
least two means to deal with preference misalignment between donors and recipients,
and rein in moral hazard on behalf of the recipient.
A first option for the donor, as suggested in Figure 1, is to substantially increase
investment in ex-ante realised transaction costs, and to spend more on gathering
information and monitoring recipient behaviour, writing a more elaborate contract with
654 Bertin Martens

the recipient, getting actively involved in the management of aid projects, etc. It
explains why some donor agencies maintain a strong presence in the administration of
aid flows, from budgeting and programming, through contracting, implementation,
supervision and evaluation (input conditionality). The administrative costs incurred to
do so are transaction costs that reduce ex-post uncertainty for the donor, making sure
that aid is used in line with his preferences. However, rather than citing non-alignment
of preferences, donors mostly justify their involvement in aid implementation by
referring to the recipients lack of skills and expertise required for project
implementation. This is not a convincing argument. Even if some projects do require
exceptional skills, the recipient could buy these skills in the market. Clearly, it is not the
quality of the skills that is the real argument here, but control over conditionality and
ex-post uncertainty. Donor-hired implementation agents tend to be more loyal to donor
than to recipient interests. This increases transaction costs (the additional costs of
subcontracting a task to an expatriate rather than a national expert) but reduces ex-post
uncertainty. In terms of Figure 1, it represents a move along the curve towards higher
transaction costs in order to reduce uncertainty.
A second option for the donor is to change the disbursement arrangements for the
aid and switch from input conditionality to results-based conditionality. In other words,
switch from paying up-front of project implementation to paying only downstream of
implementation and in function of the production of the desired results. Upstream
payment is used for most traditional project aid, motivated at least as much by the
commercial and political interests of the donor as by the recipients welfare.
Downstream or conditional aid payment is used when donors are indeed interested in
the results of an aid programme (for instance, because of political and economic
concerns). This is a typical arrangement in structural adjustment, budget support and
policy reform programmes. The problem of moral hazard by the recipient and adverse
selection by the donor is not entirely resolved, however, by this conditional approach,
since information asymmetry between donor and recipient is not eliminated. There is a
substantial volume of literature on the pros and cons of this approach (see for instance,
Killick, 1995; Mosley, 1997; Streeten, 1998; Collier et al., 1997).
The donor agencys choice of implementation arrangements with the recipient will
to a large extent be determined by the composition of the domestic coalition that
supports the aid programme. If commercial and domestic political interests are
dominant, there is unlikely to be much results-based conditionality in aid, though there
may be commercial input conditionality (tied to procurement in the donor country). On
the other hand, if genuine development lobbies are dominant, there may also be little
conditionality since these groups often favour recipient ownership rather than externally
imposed conditionality and shy away from the often painful adjustments that may be
required to put policies back on track. Results-based conditionality will only occur if
there are strong external policy concerns in the donor country about recipient
government policies. For instance, a deep economic and political crisis may jeopardise
the interests of all donor lobby groups, unleash a wave of economic and political
refugees, and provide an incentive to create a coalition in favour of more conditional aid
programmes. On the other hand, recipient countries may actively play on the diverging
interests of different donor lobbies to water down conditionality in aid programmes, for
instance by threatening commercial retaliation.
 Why Do Aid Agencies Exist? 655

In conclusion, a bilateral aid agencys margin for mediation is constrained by

diverging donor and recipient interests. It has two different institutional arrangements at
its disposal to manage this situation: a weakly leveraged but possibly domestically more
interesting input conditionality and a more strongly leveraged results conditionality that
may, however, run into domestic and recipient country opposition tactics. In terms of
Figure 1, results-based conditionality is theoretically a more efficient institutional
arrangement: it lowers transaction costs for a given degree of ex-post uncertainty or,
alternatively, reduces ex-post uncertainty for a given level of transaction costs.
However, its effectiveness depends on the underlying political support.

6 Subcontracting by bilateral aid agencies

Official aid agencies usually do not implement projects through their own staff but
delegate implementation to for-profit (companies, experts) or non-profit (NGO)
subcontractors. Consequently, official bilateral aid is usually a combination of two
institutional set-ups, the official aid agency for policy and financial decision-making
and the subcontractor for implementation. Different types of subcontractors have
different performance incentives. NGOs will maximise activity towards achievement of
their cause or the project objective, for a given contractual budget constraint. Private
for-profit companies, on the other hand, will minimise costs for a given contractual
budget constraint, in order to maximise their profits. As a result of these differences in
contractual performance incentives, the choice of type of subcontractor will also affect
ex-post uncertainty about the outcomes and transaction costs to establish and monitor
these outcomes.
If activities and results are easily observable by the donor agency, for-profit
companies have less margin to exploit their asymmetric information advantages. For
instance, the outcome of a road construction project is more easily and objectively
verifiable than the outcome of an institution-building project. To the extent that projects
are costly to monitor, moral hazard and adverse selection may occur (Martens et.al.,
2002). Increasing transaction costs to monitor the project is one solution. Another is to
select for-profit subcontractors on the basis of their track record. Measurability
problems are an obstacle to establishing performance track records, however.
If results are not easily observable, implementation through non-profit NGOs may
be a better solution. Selecting an NGO whose credibility and financial resources
depend on pursuing a specific cause or objective, increases the chances that all efforts
and resources will be geared towards that cause. Moreover, selecting an NGO that is
well-embedded in a wider socio-political network in the donor country for instance,
NGOs affiliated with political parties, labour unions, religious groups and other well-
established social organisations increases taxpayers satisfaction. These affiliations
reduce an NGOs margin for discretionary behaviour. An NGOs financial dependence
on contracts with the aid agency enables the agency to exercise some degree of control
over NGO behaviour.
Apart from formal subcontracting outside the aid agency, there is also
subcontracting inside the agency. In fact, aid agencies, like any other large
organisations, are a vast network of subcontracting of tasks from principals to their
agents. The entire aid delivery chain can thus be considered as a chain of
subcontractors, between the donor-taxpayer and the final beneficiary in the recipient
656 Bertin Martens

country. This makes the notion of a homogeneous donor unrealistic. There are many
persons involved in the delivery chain of foreign aid: private donors, taxpayers, lobby
groups, officials in aid agencies, consultants and academics, politicians in donor and
recipient countries, etc. It is usually assumed, implicitly or explicitly, that all these
individuals and organisations fully share a single objective: the alleviation of poverty
among beneficiaries in recipient countries. In reality, however, objectives are likely to
differ. Individuals pursue careers, incomes and their own preferences; they may but do
not necessarily have a genuine interest in alleviating poverty. Politicians pursue political
objectives, agencies pursue the perpetuation and expansion of their remit and budget,
consultants seek the next contract, etc. How this chain of non-aligned preferences
affects aid performance has been analysed in detail by Martens et al. (2002). The role of
aid agencies could be perceived as providing a mechanism that enables collective action
to emerge from these different and often contradictory individual motives. The agency
establishes explicit contracts and rules as well as implicit norms and standards that
affect the behaviour of individuals working with and within the organisation and,
consequently, the performance of aid organisations. In that sense, an aid agency could
be considered as the chief mediator between the preferences and interests of all persons
involved in the aid delivery chain.

7 Multilateral agencies
A large share of bilateral grant aid is actually channelled through multilateral agencies:
US$18 bn out of US$58 bn in bilateral aid (OECD, 2005: Table 12). On top of that,
multilateral development banks have their own resources (loans) to channel to
developing countries. Why do bilateral aid agencies channel part of their budget and
delegate decision-making to multilateral agencies (Milner, 2002)? How do multilateral
agencies fit into the transaction cost and agency theory picture?
Just like bilateral aid, where different domestic interest groups agree to delegate
the implementation of aid to a single government agency, multilateral aid is a case of
joint delegation by donor countries with different interests to a single international
agency. Multilateral agencies supply an institutional setting that responds to a demand
from donors as well as recipients. The literature on international and multilateral
organisations (Hawkins et al., 2003) identifies two clusters of factors that determine this
demand.
A first cluster revolves around achieving collective action in the presence of
heterogeneous preferences among donors, or between donors and recipients. Donors
may compete to promote their preferred projects in developing countries without
diminishing their own benefits or incurring additional costs (though they may induce
additional costs for the recipient). However, when the intended output of a project is a
public good, collective action among donors is required. For instance, the identification
of an economic reform programme, a debt rescheduling agreement or filling the external
financing gap of a country, requires collective action, not competition. Moreover, as
explained above, bilateral agencies may not be good at implementing programmes that
require strong conditionality because of conflicting preferences between donors and
recipients, or conflicting preferences in the donor country itself. Delegation to a
multilateral agency avoids spillover of this conflict to donors (who may prefer to
maintain a privileged relationship with the recipient) and prevents blame falling on the
 Why Do Aid Agencies Exist? 657

donor if a risky programme goes wrong (Rodrik, 1997). A multilateral approach,

endorsed by all donors and recipients, may also strengthen the legitimacy and credibility
of unpopular programmes (for instance, unpopular economic stabilisation and reform
programmes). In all these cases, the multilateral agency acts as an intermediary between
the parties. It drives a wedge between the different interest groups and uses it to design
a programme that may be supported by all parties.
A second (and partly related) cluster revolves around economies of scale and
scope, mainly in information gathering and analysis (knowledge production). National
action by individual donor countries could develop redundant capabilities, for instance
duplication of projects in similar domains or collecting information that is afterwards
put in the public domain. Multilateral approaches can reduce national costs and enhance
the credibility of that information (Rodrik, 1997). Note, however, that multilaterals do
not necessarily put all the collected information in the public domain. They may use
some of it to build up a comparative information advantage over their counterparts,
which they can exploit to selectively promote their own policy proposals. They may
specialise in specific issues for which they are the primary source of worldwide
information (the IMF on fiscal, monetary and balance-of-payments information; the
World Bank on reform policies; the WHO on health policy issues; the FAO on
agricultural and food issues, etc.). This informational advantage makes their policy
analysis and proposals more credible, and makes it more difficult for individual member
states to formulate alternative proposals. They may use these to perpetuate temporary
assignments, boost their financial resources and domains of competence, and increase
their leverage over a wide range of development policy issues.
We can add a third source of demand for multilateral agencies by extending the
economic logic of bilateral aid agencies to multilateral development banks (MDBs).
MDBs operate on the basis of loans, mobilised on international capital markets,3 in this
way enabling donor countries to supply aid to recipients at very low (close to zero)
budgetary cost to themselves. This increases the consumer surplus for donor countries:
they reap more political goodwill and economic returns from this aid than they would
be willing to pay for. This argument obviously does not apply to multilateral grant aid
agencies (MGAs)4 that operate with tax money from donor countries. There the donor
pays the full cost of the aid. The substantial consumer surplus that MDBs generate for
donor countries may explain why they are so much more important than MGAs (in
terms of volume of aid flows).
The above three factors of demand for the mediation services of multilateral aid
agencies benefit the donors; it looks as if there is not much in it for recipient countries
(though economies of scale may also benefit them). There must be benefits for the
recipient countries as well, otherwise they would not want to participate in these
institutions. A first obvious such benefit is that multilateral institutions at least partially
restore the broken feedback loop that is so typical of bilateral aid. They give recipient
countries a voice in decision-making. How much voice they get depends on voting

3. Examples include the World Bank and the regional development banks such as the European Bank for
Reconstruction and Development and the African, Asian and Inter-American Development Banks,
amongst others.
4. Examples include the United Nations Development Programme (UNDP), various specialised agencies of
the United Nations involved in thematic development programmes (WHO, FAO, ILO, UNICEF, UNHCR,
UNEP, etc.), and also the European Commissions external aid programmes.
658 Bertin Martens

systems in the multilateral agency. MDBs allocate voting rights according to shares in
the capital of the bank. Recipient countries usually have only very small shares, MGAs
or other non-bank agencies usually operate along the one-country-one-vote system,
treating all countries on an equal footing. This usually benefits the majority of
developing countries but not the minority of developed countries, although alliances are
not necessarily along these lines.
A second and probably more important and direct benefit that recipient countries
can derive from multilateral institutions is access to cheap loans, which is typical for
MDBs. MDBs are given relative financial autonomy: funds are mobilised on
international capital markets, not from taxpayers money. This gives them more room
for discretionary decision-making than grant-based aid agencies because it keeps
taxpayer supervision (through their elected representatives) at arms length.5 It also
induces a financial multiplier effect6 that benefits both donors and recipients.
MDBs are successful to the extent that they are able to drive a wedge between the
interests of donors and borrowers. Borrowing countries obtain financially advantageous
interest-rate conditions, far below the international financial market rates that
developing countries would normally have to pay, at the cost of policy conditionalities
(Rodrik, 1997). Creditor countries obtain a less contentious mechanism for collective
action on economic reforms. MDBs manage to marry the often conflicting objectives of
donor and recipient countries, at a price to both: namely, the relative independence of
the MDB. Of course, to the extent that one or a few large shareholders dominate voting
on the Board of the MDB, these countries may still lean heavily on decision-making and
reduce the MDBs independence: for instance the position of the US, and the G7 in
general, on the boards of the World Bank and the IMF. MDBs have managed to
circumvent some of the problems and exploit the advantages associated with joint
delegation.
Some MDBs combine this financial advantage with an informational advantage.
They gather worldwide or at least region-wide information and use their economies of
scale in this process to strengthen their informational advantage over donors and
recipients alike. Informational advantages are useful in presenting policies and make it
harder for outsiders to verify the validity of the analysis and the policy proposals,
especially when some information is not made publicly available or at least is hard to
access. It also enables these MDBs to become involved in normative work and
standard-setting, which may include international regulatory standards as well as setting
aid policy standards. Economies of scale in information gathering also put MDBs in an
advantageous position for co-ordinating international aid. For instance, the World
Banks unique position as a worldwide MDB gives it a comparative advantage in
overall information gathering and analysis, which can be exploited to its own
advantage. Together with the IMF,7 it is mostly in the lead position in the design of
economic policy reform programmes in developing countries, partly because of this.

5. Many MDBs have so-called soft windows that mix loans and grants into loans at a subsidised interest
rate. To the extent that soft lending plays an important role in an MDB portfolio, donor supervision may
come closer.
6. The combination of a gearing ratio (ratio of lending to capital) above 1 and a ratio of effectively paid-in
capital below 1 results in a strong multiplier effect: for each dollar invested by donors in the capital of an
MDB, many dollars can be lent by the MDB to recipient countries.
7. The IMF is not a typical MDB but shares many behavioural characteristics with MDBs.
 Why Do Aid Agencies Exist? 659

MGAs have two major disadvantages compared with MDBs. First, they use
taxpayers money from donor countries, which makes it harder to keep donors national
political and economic interests at arms length. Membership contributions are usually
based on GDP, so that the industrial countries share the largest budgetary burden.
Obviously, donor representatives will want to keep a close eye on how that money is
spent and to further their own interests through the spending process. Second, most UN
agencies operate as co-operative clubs, with both donors and beneficiary countries
represented in decision-making bodies that follow the one-country-one-vote rule. This
gives recipient developing countries an overwhelming majority in decision-making and
creates an obvious disequilibrium between financial contributions and voting power.
However, in many cases donor countries have various means at their disposal to
reverse this disequilibrium. Obligatory membership contributions feed only into the
regular budget. A considerable part of donor contributions for specific research projects
and aid programmes is kept off-budget and at the discretion of donors. This
discretionary financing channel enables them to influence decision-making. Also, most
agencies take care not to approve a budget that runs counter to the interests of the major
donors. This is particularly important in the realm of the so-called normative activities
of various specialised UN agencies, such as WHO, FAO and ILO, which are involved in
setting worldwide standards and regulations in their domain of competence. Donor
countries can use these financial levers to forge coalitions and ensure that standard-
setting does not operate against their interests.
This careful balancing act between financial and voting power, and between
normative and development aid activities, opens a window of opportunity for the
multilateral agency to exploit its position, launch proposals and forge coalitions in their
favour. It allows the agency to work itself into a key position as an agenda-setter and
policy-maker and justify its existence as an enabling environment for collective action
among its member states. This explains why donors and their bilateral aid agencies are
willing to channel part of their foreign aid through multilateral specialised agencies.
Multilateral agencies are uniquely placed to promote collective action in their domain of
competence. It is in a donor countrys interest to be a member of these organisations so
as to be able to voice its interests in international policy-making. Foreign aid can be
used as a lever to enhance its policy influence and reduce uncertainty, perhaps not so
much in the execution of development projects but more so in normative decision-
making. It helps a donor country to redress its disadvantage in voting power over
normative issues and other policy decisions in general.
In a way, MGAs constitute a two-sided institutional arrangement: a financial
institution and a normative institution. The normative institution has high ex-post
uncertainty for the donors because they are usually in a minority. The financial
institution has low uncertainty because of the financial leverage it gives to the donors, in
return for a high transaction cost (grant contributions). Combining the two strikes a
political balance acceptable to both donors and recipients. MGAs that neglect either of
these sides risk losing credibility and status in the international aid community.
660 Bertin Martens

8 Conclusions
The analysis in this article enables us to answer the Coasian questions (a) why aid
agencies exist, (b) why there are many of them instead of just one and (c) what are their
distinguishing institutional features.
Like all other institutions, aid agencies exist to reduce ex-ante transaction costs
and ex-post uncertainties in transactions in this case, income transfers from donors to
recipients. Transaction costs exist for various reasons: the cost of collecting funds and
channelling them to the recipients, the cost of collecting information on and selecting
potential recipients, the cost of monitoring the implementation of aid projects, etc. Ex-
post uncertainties arise because both parties have different and incomplete perceptions
of the others preferences and objectives. Combined with imperfect and asymmetric
information between the parties, this may give rise to moral hazard and adverse
selection. In a hypothetical world without transaction costs and contractual
uncertainties, there would be no need for aid agencies; private markets would deal with
aid transfers. In the real world, with positive transaction costs and uncertainties, aid
agencies provide economies of scale and institutional arrangements that reduce costs
and mediate between donors and recipients to reduce uncertainties due to diverging
preferences. This institutional explanation for the role of aid agencies is quite different
from the traditional view whereby their role is to transfer financial resources to
recipients (this could be done in much simpler ways) and/or to supply recipients with
goods, services and know-how (no need for an aid agency since these can be bought in
the market).
If all donors were fully to share a single objective for instance, poverty reduction
then one single worldwide aid agency would be sufficient. It would maximise
economies of scale in the collection of funds, selection and monitoring, policy
discussions and simplification of aid modalities. The fact that a multitude of aid
agencies exists constitutes a strong indicator that a single fully shared aid objective is an
unrealistic assumption. Public aid decisions are the result of a political compromise in
donor countries, or between donor countries in the case of multilateral aid, that reflects
a mixture of diverging preferences of different domestic lobby groups. Moreover, that
domestic compromise is unlikely to fully reflect the recipients preferences since he is
not taking part in the decision-making process. Forcing donor countries and lobby
groups worldwide to adhere to a single aid objective such as poverty reduction, or even
a limited set of objectives such as those identified in the Millennium Development
Goals, will limit the margins for political compromise around these diverging
preferences and thereby reduce some groups willingness to pay for aid. In fact, if
donors and recipients were fully to share a preference for a single objective, there would
be no need for any aid agency at all. Aid could be sent direct by cheque to the recipients
and they would take care of policies and implementation, using goods, services and
knowledge bought on international markets.
Different types of aid agencies serve different purposes, depending on their
institutional architecture. Private or non-governmental agencies can offer economies of
scale and, more importantly, a transaction-cost-efficient mechanism to reduce ex-post
uncertainties in the use of private gifts. However, their financial leverage is limited:
donors interested in giving aid pay the full cost of the transfer and do not enjoy a
consumer surplus. Official aid agencies have stronger financial leverage because they
 Why Do Aid Agencies Exist? 661

can increase consumer surplus for domestic interest groups, including genuine aid
lobbyists and commercial suppliers of aid services. Tax money is used, sometimes as a
complement to but often instead of private funds, to support the goals of these domestic
interest groups. As such, these groups do not pay the full consumer value that aid has
for them.
Similarly, multilateral development banks increase the consumer surplus or
goodwill surplus for donor countries. Their funds are raised in international financial
markets instead of using donor country tax money. Donor countries do not pay the cost
of the aid, despite their domestic policy interest in these aid transfers. To the extent that
multilateral banks use soft lending windows, subsidised by donor country grants,
donors pay part of the cost, of course. At the same time, multilateral banks offer cheap
loans to the borrowing countries, below the market rates they would normally have to
pay, thereby increasing the borrowers consumer surplus. The price that donors (and
borrowers) pay for this increased consumer surplus is a loss of control in ex-post
contractual uncertainties. Monitoring contracts and uncertainties is delegated to the
bilateral or multilateral agency that may only partly satisfy the (often diverging)
preferences of all parties concerned.
These conclusions cast new light on the current aid policy agenda. The aid
community has apparently rallied in recent years around the single overriding objective
of poverty reduction. Moreover, donors and recipients are making efforts to enhance
recipient ownership, harmonise policies and procedures to reduce transaction costs and
seek convergence in objectives. The World Bank, for instance, adopted the new
Development Policy Lending instrument in 2004, to replace structural adjustment
lending. It explicitly seeks to strengthen recipient country institutions and enhance
ownership by recipient governments in consultation with stakeholders, abandoning the
prescriptive character of previous lending approaches and taking a more long-term
programmatic approach. These policy changes have also been concretised in general aid
policy documents such as the Millennium Declaration (2000) and, recently again, in the
Paris Declaration on Aid Effectiveness (2005).
Strengthening recipient countries institutions, with or without donor aid, would
certainly constitute an improvement in governance in terms of Figure 1: it would reduce
aid transaction costs for the same level of ex-post uncertainty and would thus provide
additional assurance to donors that aid will be used for the agreed purposes and in the
agreed ways. However, it does not necessarily bring donor objectives closer to those of
the recipients, or bring more coherence among individual donors objectives, for that
matter. The Paris Declaration implicitly acknowledges this when it advocates linking
aid to a single set of conditions and aligning it behind central government strategies to
the maximum extent possible: it leaves room for divergence among donors, and
between donors and the recipient government authorities, and even for bypassing
national institutions when these can not be relied upon. To the extent that donors
preferences would fully converge, there would be no need to maintain a multitude of
donor agencies; all donors could delegate aid delivery to a single agency, for instance
the World Bank. Fortunately, this is not a realistic policy because there is a healthy
divergence of views among donors; nobody holds a monopoly on solutions to
development problems. To the extent that recipient countries were to go through a fully
transparent and democratic consultation process with all stakeholders which is
unfortunately not the case in many developing countries donors might simply give an
662 Bertin Martens

unconditional lump sum aid to the central government treasury to implement the
recipient countrys agreed policies. Even in this case donors may still disagree with the
recipient government and attempt to sponsor their preferred recipient country lobby
groups and policies.
The main policy conclusion to be drawn from this article is that, as long as donors
and recipients live in different political constituencies with no overarching political
institution to work out a policy compromise between them, aid agencies will fill that
gap and act as mediators between donors and recipients, proposing aid delivery
instruments that reduce transaction costs and ex-post uncertainties in delivery. During
the 1980s and early 1990s the aid policy pendulum had swung in favour of donor-
prescribed conditionality. In recent years, the pendulum has swung back towards the
recipients, emphasising ownership and donor alignment. Neither donors nor recipients
can be forced into a policy straitjacket without a cost to the other party. Excessive
emphasis on recipient ownership, a single aid objective, and harmonisation and
alignment of procedures and policies, may increase benefits for the recipients but may
also diminish donors willingness to pay because it reduces their perceived consumer
surplus in terms of their own domestic policy interests. It is precisely the role of aid
agencies to broker a realistic compromise between the parties concerned, each
according to its own institutional abilities and comparative advantages.
first submitted May 2005
final revision accepted August 2005

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